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One-Size-Fits-All Paternalism

November 18, 2008

By Chidem Kurdas

A 2006 federal law encouraged employers to enroll workers automatically in 401(k) retirement accounts and invest the money in diversified mutual funds. The default option in many cases is a target-date fund that invests in stocks and bonds.

Workers can opt out or change the investment, but many do not. This has been toted as a successful application of the new, soft interventionism advocated, for instance, by Cass Sunstein and Richard Thaler in their book Nudge.

People who previously did not pay much attention to those automatic 401(k) investments may now take notice when they see the losses. A target fund changes its asset mix to reduce risk as retirement approaches, with bonds looming larger the closer the person comes to retiring. Turns out, though, that target-date funds differ widely in the proportion of bonds and stocks, and hence the return.

According to the Wall Street Journal, target funds for people expected to retire in 2010 varied from a loss of 32% to a loss of 14% through Oct. 30th. Click for WSJ article.

Sharp losses are not specific to default 401(k)’s, of course. Downturns across different markets pounded almost all portfolios this year. But some target-date funds did not do what they were supposed to do, namely provide a safe nest egg by keeping stocks to a minimum and investing mostly in high-quality bonds close to retirement.

Worse, people who did pay attention and made deliberate choices to tailor their 401(k) to their liking did not necessarily succeed in that goal. Employers can move all participants’ savings into the default fund, on the ground that the investments were not appropriately diversified. Again, employees can opt out, but they don’t always notice and take action.

Individuals have different attitudes toward risk, so a default fund that fits some preference sets violates others. It would seem that even gentle paternalism causes harm with its unintended consequences and uniform remedies. We may choose poorly left to our druthers as Sunstein and Thaler say, but do others really know what’s better for us?